Merger arbitrage and undervalued stocks are appealing to this portfolio manager, but she's waiting on distressed debt.

    With the fallout in subprime loans deflating the corporate bond market, it would be logical to assume a fund that includes distressed debt as one of its strategies would be scooping up bargains. But Anne Gudefin is not convinced that the time is ripe for bargain hunting. "There is no doubt that the amount of leverage in the system is going to cause some problems, but it is still too early for specific opportunities," says the 41-year-old manager of Franklin Templeton's Mutual Qualified Fund.
    The picture was different in late 2003, the year Gudefin took over as lead manager. The fund had about one-fifth of its assets in the bonds of deeply troubled companies purchased over the previous three years at a substantial discount to their face value. After the financially distressed companies had reorganized in bankruptcy court, the old debt was replaced with new securities issued by the financially stronger companies. Now, after closing out those positions, Gudefin is content to wait things out before stepping in.
    As the bond market drama unfolds, the manager of the $6.6 billion fund has moved to more productive hunting grounds in merger arbitrage, which, along with distressed debt and undervalued securities, represents one of the three underpinnings of the fund's approach to uncovering value in nontraditional places. Merger arbitrage is a complex and highly special area that has a low correlation to the stock market.
    When companies announce proposed mergers or takeovers, the target may continue to trade at a discount to the bid it ultimately accepts, since the transaction could hit a snag or fall through. A big disparity between the market price after the announcement and the acquirer's offer means that investors are fearful that a deal will be canceled or delayed, while a narrow spread indicates confidence in a swift and successful conclusion.
I    n August, investors pulled money out of merger arbitrage plays and widened spreads as the fallout in private equity and leveraged buyouts created doubts about whether the proposed deals would get the financing they needed to go through. But the backlash also extended to pending deals involving financially solid buyers such as France's Groupe Danone and Germany's Siemens. "These companies are among the largest in their respective countries and should have no trouble obtaining financing, so there was no reason to think these acquisitions would fall through," she says.
Despite having a foot in the merger arbitrage door, Gudefin keeps most of the fund's assets in undervalued stocks. "I like investing in a stock when no one else is interested and there is a big discrepancy between the share price and company value," she says. "With lots of selling going on, this is a perfect time for us."
    Recent purchases include oil services company TransOcean, which controls one of the world's largest deepwater drilling fleets. With oil companies slow to replace oil reserves or to invest in exploration, the company is poised to tap the growing demand for deepwater drilling. French oil and gas services company Geophysique is another holding in that sector. "By 2015, ultra-deep offshore drilling will represent 15% of oil production, compared to 3% in 2005. This is a growing area primed for consolidation," she says.
    Since the beginning of the year she's been nibbling at shares of Japan Tobacco, the world's third-largest tobacco company and the force behind such brands as Winston and Salem. Gudefin believes that investors, who have been focusing heavily on disappointing sales, have failed to recognize the bargain that the stock represents. The company has ample free cash flow and has used it to buy back its shares.
    Free cash flow is critical to Gudefin, who believes a stock is undervalued when its price does not reflect the sum-of-its-parts intrinsic value of its business. The industry the issuer is in must have high barriers to entry and there must also be a catalyst for change, such as new management, a restructuring or a merger that will add value. Often, she will comb the market's rubble for asset-rich companies whose shares are trading at depressed levels because of concerns such as short-term earnings disappointments, litigation or other perceived negatives.
    Gudefin came to Mutual Series in 2000 after interviewing with fellow deep-value devotee David Winters, the former president and chief investment officer who left in May 2005 to launch his own firm and the Wintergreen Fund. Before that, the Paris native, whose American father worked for Lazard Freres, was an equities analyst specializing in European value stocks at a New York hedge fund.
    Winters is just one of a number of high-level investment professionals who have departed the firm in recent years. Mutual Qualified has had three managers over the last six years, including Ray Garea, who left in July 2001, and Jeff Diamond, who bowed out in 2003. Gudefin, the fund's former assistant manager under Diamond, assumed control after his departure and moved to the firm's London office to be closer to the European markets last year. Since she took over, Mutual Qualified has acquired a more foreign flavor. U.S. securities account for 36% of assets, down from over 50% three years ago, with ample representation from countries such as France, the U.K., South Korea and Germany.
    Gudefin, who also runs Winters' former charge Mutual Discovery, recently ran into him for the first time in years at a conference on the tobacco sector, a longtime favorite of both. "These companies have a lot of the things I look for in a stock," she says. "The industry has a high barrier to entry because the existing brands are so entrenched. They have lots of free cash flow to buy back shares, and the ability to step up pricing."
    Tobacco holdings include British American Tobacco and Spain's Altadis. The latter company has been fund-holding since 2000. In March 2007, it received an unsolicited offer from U.K.-based Imperial Tobacco, which boosted its share price. The proposed merger would make Imperial the second-largest tobacco company in Europe, as well as consolidate its place as fourth biggest in the world. As of mid-September, the deal appeared to be on track.
    To help limit risk, Gudefin spreads her bets widely between 130 and 150 stock positions, with the top ten positions accounting for approximately 25% of assets. Her average holding period is three to five years, reflected in the fund's sedate portfolio turnover rate of 24%. When she has trouble finding securities she likes, she will put money into cash, which accounted for 14% of assets during the summer. The fund's top sectors include food, beverage and tobacco at 21% of assets, followed by insurance at 10.5% and capital goods at 8.5%.
    Orkla, one of Norway's largest conglomerates and the fund's second-largest holding, has been a top performer this year. The fund bought the stock five years ago at a significant discount to its intrinsic value, and the company has since sold some assets, refocused its portfolio, and put in place a turnaround program for some of its consumer goods businesses. This year, the company increased its stake in solar energy solution company Renewable Energy Corp. at a significant discount to that firm's market price. It also merged part of its aluminum business with Alcoa.
    Florida East Coast Industries, a railroad company with significant real estate interests, has been in the fund for decades. Earlier this year, railroad stocks appreciated as investors focused their attention on the companies' underleveraged balance sheets. Despite lower carload volumes shipped on the railroad and a general decline in its real estate assets, Florida East Coast shares rose after the company received an offer to take it private in a leveraged buyout at a significant percentage premium to its stock price.
    Disappointments this year include Sovereign Bancorp, which sank as investors' short-term outlook for the bank fell below that of its peers and a rumored acquisition by a Spanish bank failed to materialize. Another holding, California-based semiconductor developer LSI, skidded after management lowered its outlook for operating profits because of continued softness in industry demand, excess inventories and the underperformance of one of the company's recent acquisitions. And shares of Dutch bakery supply and food ingredient producer CSM retreated as a previously announced restructuring program failed to deliver results in the first half of the year. Hedging against foreign currency exposure also hurt the fund as the U.S. dollar continued to weaken against foreign currencies.
    Despite these problems, "the fund's solid long-term returns and below-average volatility make it an appealing core holding," notes Morningstar analyst Bridget B. Hughes in a recent report. "However, it's light on large caps and all but ignores growth sectors, so investors may wish to pair it with a fund that gives them exposure to these areas." As the smallest of the diversified Mutual Series funds, she adds, the portfolio provides additional flexibility to invest in less liquid investments.